Corporate Governance Disclosure Index–Executive Pay Nexus: The Moderating Effect of Governance Mechanisms

• Date: 01 March 2020
• DOI: http://doi.org/10.1111/emre.12329
• Published date: 01 March 2020

Corporate Governance Disclosure

Index–Executive Pay Nexus: The Moderating

Effect of Governance Mechanisms

MOHAMED H. ELMAGRHI,

1,2

COLLINS G. NTIM,

3

YAN WANG,

4

HUSSEIN A. ABDOU

5,6

and ALAA M. ZALATA

3,7

1

Department of Accountancy, Finance and Economics, Huddersfield Business School, University of Huddersfield, Huddersfield,

UK

2

Department of Accounting and Finance, Al Asmariya University Business School, Al Asmariya University, Zliten, Libya

3

Centre for Researchin Accounting, Accountabilityand Governance, SouthamptonBusiness School, University of Southampton,

Southampton, UK

4

Department of Accounting and Finance, Leicester Business School, De Montfort University, Leicester, UK

5

Faculty of Business and Enterprise, The University of Central Lancashire, Preston, UK

6

Department of Management, Faculty of Commerce,Mansoura University, Mansoura, Egypt

7

Department of Accounting, Faculty of Commerce, Mansoura University, Mansoura, Egypt

This paper first employs principal component analysis technique to develop and introduce an alternative UK

corporate governance disclosure index to the US-centric ones. Second, we then investigate whether this new

corporate governance disclosure index can determine the level of executive pay (including CEOs, CFOs, and all

executive directors) in UK listed firms, and consequently ascertain whether the governance mechanisms can

moderate the pay-for-performance sensitivity. Employing data on corporate governance, executive pay and

performance from 2008 to 2013, we find that, on average, better-governed firms tend to pay their executives

lower compared with their poorly-governed counterparts. Additionally, our findings suggest that the pay-

for-performance sensitivity is generally positive, but improves in firms with high corporate governance quality,

implying that the pay-for-performance sensitivity is contingent on the quality of internal governance structures. We

interpret our findings within the predictions of optimal contracting theory and managerial power hypothesis.

Keywords: corporate governance disclosure index; corporate performance; executive pay; endogeneity; principal

component analysis; UK combined code

Introduction

The agency theoretic literature has suggested several

monitoring (e.g., good corporate governance practices)

and incentive alignment (e.g., executive pay packages)

mechanisms that can be employed to mitigate agency

conflicts in modern corporations (Jensen and Meckling,

1976; Fama, 1980; Fama and Jensen, 1983; Beatty and

Zajac, 1994). Noticeably, studies examining the extent to

which executive pay packages can be used to mitigate

agency problems in public corporations are underpinned

by two main theoretical perspectives with deep roots in

rational agency theory: (i) managerial power hypothesis;

and (ii) optimal contracting theory (Jensen and Murphy,

1990; Bebchuket al., 2002; Mallin et al., 2015; van Essen

et al., 2015). Briefly, the managerial power hypothesis

assumes that in firms with weak corporate governance

structures, opportunistic and powerful corporate

executives directly determine their own pay packages by

controlling the executive pay setting process (Bebchuk

et al., 2002), and thus the managerial power hypothesis

does not expect executive pay to be necessarily related

to corporate performance. Managerial power hypothesis

can, therefore, be more applicable under a poor corporate

governance regime. By contrast, the optimal contracting

theory suggests that executive pay results from arms-

length negotiations betweenindependent corporate boards

Correspondence: Dr Yan Wang, Department of Accounting and Finance,

LeicesterBusiness School, De MontfortUniversity,Leicester, UK,

Tel: +44 (0)116257 7211. E-mail yan.wang@dmu.ac.uk

DOI: 10.1111/emre.12329

©2018 European Academy of Management

European Management Review, Vol. 17, –(2020)

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–,

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and managers, leading to executive pay packages that are

able to optimise managerial performance (Edmans and

Gabaix, 2009; Conyon, 2014), and therefore the optimal

contracting theory expects a strong pay-for-performance

sensitivity (PPS). Hence, the optimal contracting theory

can be expected to operate better under a good corporate

governance condition.

Due to varied reasons underlying executive pay,

Amzaleg et al. (2014), Core et al. (1999, 2003), Murphy

(1999), Newton (2015), and Sapp (2008), among others,

have strived to investigate its determinants. However, the

existing literature suffers from a number of observable

limitations. First, despite the importance of good

corporate governance practices and the considerable

amount of corporate governance reforms that have been

pursued worldwide (Aguilera and Cuervo-Cazurra,

2004), existing literature, such as Amzaleg et al.(2014),

Conyon and Murphy (2000), and Ozkan (2011), has

almost focused exclusively on how or whether executive

pay can be influenced by corporate performance/PPS,

but performance is arguably only one possible

determinant of executive pay. In contrast, few studies,

such as those conducted by Adams and Ferreira (2009),

Conyon (1997), Dong and Ozkan (2008) and Ozkan

(2011), have examined whether and how firm-level

corporate governance structures may influence executive

pay, and thereby limiting current understanding of the

effect of good corporate governance practices on

executive pay.

Second, from a theoretical and practitioner point of

view, corporate governance is important in corporate

decision-making and thus, should and is expected to

influence corporate outcomes (Larcker et al., 2007; Foss

and Stea, 2014). Indeed, this expectation is reflected in

the large volume of studies that have investigated the

effect of different corporate governance mechanisms on

different managerial behaviour and corporate outcomes

(e.g., Morck et al., 1988; Yermack, 1996; Murphy, 1999;

Gompers et al., 2003; Donadelli et al., 2014; Serra et al.,

2016; Granado-Peiró and López-Gracia, 2017). However

and as corporate governance is a complex ‘concept’to

operationalise, existing studies have either mostly

employed single corporate governance mechanisms, such

as board size and ownership structure (e.g., Morck et al.,

1988; Yermack, 1996) or some form of arbitrarily

constructed composite governance disclosure indices

(e.g., Gompers et al., 2003;Bebchuk et al., 2009; Karpoff

et al., 2016). Observably, and despite a general consensus

on its importance, the findings of a vast majority of

existinggovernance studies are mixed, and therebyraising

major questions as to whether these governance

‘constructs’that are often employed are actually ‘valid’

proxies (single governance structures or governance

disclosure indices) for the complex concept

(‘governance’) that they seek to measure (‘construct

validity’) (Black et al., 2017). On the one hand, Larcker

et al. (2007, p.964) argue that the potential measurement

error that may be introduced from employing the use of

single governance mechanisms (e.g., board size), “will

almost certainly cause the regression coefficients to be

inconsistent”.

On the other hand, other researchers have sought to

address the measurement error issue by constructing

governance indices that contain multiple provisions.

There are, however, three major problems associated

with such indices. First, and because there is no

theoretical basis for selecting governance provisions,

such indices are often naively constructed (Brown and

Caylor, 2006), and thereby equally resulting in similar

measurement errors (Larcker et al., 2007; Black et al.,

2017). Second, it is not only practically impossible to

include all relevant governance provisions, but also

likely that not all the included provisions will be

relevant, and therefore measurement problems, such as

omitted variables bias are likely to persist in such

governance indi ces (Larcker et al., 2007; Black et al.,

2017; Karpoff et al., 2016).

1

Consequently, a small, but

gradually increasing number of researchers have recently

employed statistical approaches in developing more

reliable governance indices (e.g., Black et al., 2017;

Karpoff et al.,2016; Larcker et al., 2007). Larcker et al.

(2007), for example, employ principal component

analysis to develop an alternative disclosure index

containing 14 key components out of 39 governance

provisions for US firms, and they demonstrate that it is

more reliable and better specified compared with

previous ones, such as the G-disclosure index. We thus

employ the principal component analysis approach to

develop an alternative corporate governance disclosure

index for UK firms.

Third and despite increasing anecdotal evidence

suggesting that other corporate executives below the

CEOs, such as CFOs pay packages are getting equally

significant in magnitude, existing studies have mainly

investigated the antecedents of CEO pay (e.g., Core

et al., 1999; Dong andOzkan, 2008; Adams and Ferreira,

2009; Fahlenbrach, 2009; Guest, 2009; Gregory-Smith,

2012; Jouber and Fakhfakh, 2012), and thereby relatively

1

Forexample, Gompers et al. (2003)constructed an influentialequally weighted

governancedisclosure index(‘G-index) that contained24 US shareholder rights

provisions and showed that firms with poorgovernance had lower operating

profits,market valuation and stock returnscompared with their better-governed

counterparts. However, successive researchers, such as Cremers and Nair

(2005), Bebchuk et al. (2009) and Karpoffet al. (2016) have demonstratedthat

only six (entrenchment-index, E-index), 18 (other-index, O-index), and 12

(deterrent-index, D-index)of the 24 governanceitems, respectively, are relevant

and often not justcontradicting the findingsof Gompers et al. (2003), but also

among themselves. In addition, these indices are generallyfor US firms with

no alternative(there are few commercial agencies,such as Governance Metric

International,Institute of Shareholder Service, Credit LyonnaisSecurities, and

Standard& Poors, that construct commercialindices for sale, but they are often

copyrightedand not freely available)indices for othercountries, such as the UK.

M.H. Elmagrhi et al.

©2018 European Academy of Management

122

little is known about the impact of firm-level corporate

governance on thepay packages of other executives,such

as CFOs and all other executive directors.

Fourth, the existing studies that have investigated the

executive pay-performance nexus generally suggest that

the relationship is positive, but weak (e.g., Jensen and

Murphy, 1990; Main et al., 1996). However, a major

limitation of these studies is that they only control for a

small number of corporate governance variables that

may affectthe PPS. In response to this limitation, the more

recent and subsequent studies have controlled for a large

number of corporate governance mechanisms (i.e.,

including board and ownership structure), when

examining the link between executive pay and corporate

performance (e.g., Conyon, 1997; Core et al., 1999;

Hartzell and Starks,2003; Dong and Ozkan, 2008; Guest,

2009; Ozkan, 2011; Gregory-Smith, 2012; Jouber and

Fakhfakh, 2012). However, and despite controlling for a

large set of corporate governance variables, these studies

report similar positive and weak PPS. An observable

limitation of these studies is that they do not sufficiently

consider possible endogeneity concerns that may result

from simultaneously employing both the incentive

alignment (executive pay) and monitoring mechanisms

(corporate governance) by firms to reduce agency

conflicts (Ntim et al., 2015a, 2015b). Arguably, this may

explain the observably weak PPS reported by paststudies

and may also limit current understanding of the extent to

which firm-level corporate governance quality can

moderate the link between executive pay and firm

performance. Finally, and despite the theoretical and

empirical suggestions that most corporate decisions,

including executive pay is mainly a function of top

management team and ownership structure (Ntim et al.,

2015a, 2015b),there is a clear dearth of studies examining

how board structure,CEO power and ownership structure

variables may affect executive pay. Arguably, this also

limits our understanding of the extent to which board

structure, CEO power and ownership mechanisms can

impact executive pay.

Given these noticeable weaknesses of the extant

literature, we seek to investigate the impact of firm-level

corporate governance on executive pay and the PPS

among UK listed firms. There are a number of reasons,

which motivated us to focus on the UK corporate setting.

First, since 1992, the UK has been at the forefront of

pursuing arguably the most influential global corporate

governance reforms (Greenbury Report, 1995; Hampel

Report, 1998; DRR, 2002; Higgs Report, 2003; Smith

Report, 2003; FRC, 2010a, 2010b, 2012a, 2012b). For

example, most countries around the world have adopted

the recommendations of the 1992 Cadbury Report, and

intergovernmental organisations, such as World Bank,

have also issued guidelines and principles, which reflect

the content of the UK corporate governance codes. Thus,

the findings

2

of our study may not only be relevant to the

UK, but also to other countries, which are currently

pursuing corporate governance reforms around the world.

Second, the UK has strong shareholder activism with a

good track record of implementing and enforcing

corporate regulations. Third, the markets for products,

services, capital, managerial and corporate control are

fairly active, and thereby serving as an effective external

corporate governance mechanism that can restrain

executive abuse. Arguably, these contextual charac-

teristics make the UK an ideal corporate environment to

examine the impact of corporate governance practices on

executive pay and the PPS.

This study, therefore, seeks to extend, aswell as make a

number of new contributions to the growing body of

literature on the antecedents of executive pay. First, it

contributes to the literature by employing a principal

component analysis technique to develop and introduce

a new alternative governance disclosure index containing

31 key componentsout of 120 comprehensive governance

provisionsfrom the UK Combined Code for UK firms and

researchers. Second, it contributes to the extant literature

by examining the impactof a broad corporate governance

disclosure indexon executive pay.Third, we contribute to

the existing literature by providing evidence on the extent

to which board structure (i.e., board size and diversity),

CEO power (i.e., CEO tenure, CEO duality and CEO

pay slice), and ownership structure (i.e., managerial,

institutionaland block ownership) can explaindifferences

in executive pay. Fourth, this study contributes to the

literature by providing new evidence on how corporate

governance can i mpact on the annual cash (i.e., bonu s,

salary, and other cash payments) and equity-based

(i.e., performance share plan and any other long-term

incentive plans) pay of CEOs, CFOs and all other

executive directors. Finally,given that direct ors’incentives

and corporate governance mechanisms may act either as

complements and/or substitutes, it distinctively seeks to

contribute to the existing literature by investigating

whether corporate governance can moderate the PPS. We

employ traditional ordinary least squares regressions in

addition to lagged-effects, fixed-effects, GMM and

2

We note that althoughthe recommendationsof the 1992 Cadbury Reporthave

been adopted worldwide, the UK has different economic system and

characteristics comparedto not only developing countriesthat adopted the code,

but also to other developedcountries. For example, the markets for products,

services and corporate control are moreactive in the US than UK, and this is

due to the fact that competition in the UK is tightly controlled by the

Competition and Markets Authority. Further, shareholder activism is stronger

in US. In contrast, stakeholder activism (i.e., general public outrage and

activism)is much stronger in the UK. Additionally, firms in civil law countries

(e.g., Germany and France) are characterised by weak protection of minority

shareholders compared with firms in common law countries (e.g., UK and

Ireland).Therefore, our resultsshould be interpretedwith great caution because

there are apparentdifferences even amongdeveloped countries.

CG Disclosure Index–Executive Pay Nexus

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